2015 Update: The Effect of Basel III Global Banking Rules on Preferred Shares

In Canadian Banking regulations preferred shares are considered "Tier 1 Capital" when a bank is "stress tested" for viability. In Canada there is a strict minimum for Tier 1 Assets and it is beneficial for banks to issue preferred shares to meet this minimum. Canadian banks passed through the 2008 crash with hardly a scratch because the Canadian rules forced on them (including what made up Tier 1 Capital) were some of the best on the planet...but global problems are forcing changes in these rules.

In 2012 the Basel Committee on Banking Supervision established new global rules for measuring "capital adequacy". The rules are voluntary but if you want to do international banking you must sign up. The rules are implemented in a phased approach and Basel III affects preferred shares.

By 2022 banks can no longer use preferred shares as Tier 1 Capital. Banks are welcome to issue preferreds but they no longer have any benefit in the Canadian context. As we approach 2022 it is very likely no new preferred shares will be issued. Many of the existing preferred shares will be "called" and redeemed at the $25 face value (if that is allowed in the terms of the issue). If they are not called the terms will be "degraded" so holders will convert to common shares or sell them for better investments.

The story below is still valid for preferred shares until 2022 (not exactly set and forget). It remains valid for common shares forever (well at least the next 100 years)...back to your regularly scheduled programming...


If I Won a Million Dollars...

Everyone buys a lottery tickets. Even the smartest of us buy them a couple of times a year. They are a terrible investment. The expected return is 35% for a well run government lottery (invest a million dollars in tickets and expect to win $350K). The return from lotteries run by charities are less and returns from your local bookie are much, much less. You should never expected to win anything but what if you won?

"I spent most of my money on women and booze...and wasted the rest."

If you believe (as Sooty does) that you should expect to live forever. then a good plan would be to build an income stream that will last as long as you do...you know...so you don't have to work forever.

Forget the aggressive "value investor" from Investing 101. You want a safe income stream that you can buy and forget. A monthly cheque you don't have to worry about. One that keeps up with inflation.

This puts you in the market for dividend paying shares from big companies that have been around forever and will never fail...that is they violate the Investing 101 rule that all "stocks go to zero".

In Canada the big banks are about as close as you can get. Canadian banks are heavily regulated and very safe as evidenced by their easy pass through the 2008 crash. The Royal Bank has paid a gradually increasing dividend without a break for over one hundred years. Not quiet forever but close.

The rate of return is around 5% which means if you took a one million lottery wining and bought bank shares you would get a perpetual annual income of $50,000 (in constant 2014 dollars). Not enough for a gold plated Rolls but the income of an average Canadian. With all that free time you can take up painting, or write a book, or invent something.


Preferred Shares Terms and Conditions

Common shares make you an owner of a company so you get to vote on things like who is on the board and who audits the books. Since you'll never get more than the most miniscule fraction of the outstanding shares your voting rights aren't worth much.

Dividend paying common shares have risk. You get no dividend if the company makes no money. The dividend rises and falls based on company profits. Canadian banks are especially stable (because they are heavily regulated) and their common stock has always paid a gradually increasing dividend.

Canadian banks also offer a large number of preferred share issues. These exist in a realm between common shares and bonds. Like bonds they are non-voting so you don't get a say on bank operations. Also like bonds they come with a large number of terms and conditions. You need to read the Prospectus carefully to fully understand what makes issues from CIBC different from those issued by RBC. Even from the same bank there will be differences between their Series 15 and Series 21.

Many companies offer preferred shares and they can have an enormous variety of conditions (put "preferred shares" into Wikipedia). About the only thing "preferred" tells you is that their dividends are paid in full before the common share holders get any dividends. So you lose voting rights for a better place in line when the company is profitable. Ahead of you are the bond holders who always get paid in full even if the company is losing money.

Preferred shares from Canadian banks are easier to evaluate. You will find that all the banks and all the share issues from each bank have almost identical conditions (but check anyway). Below is an extract from the Prospectus (36 pages) for CIBC Series 35 Preferred shares (CM.PR.L):

For each five-year period after the Initial Fixed Rate Period (each a "Subsequent Fixed Rate Period"), the holders of Series 35 Shares will be entitled to receive fixed non-cumulative preferential cash dividends, as and when declared by the Board of Directors, payable quarterly on the 28th day of January, April, July and October in each year, in the amount per share per annum determined by multiplying the Annual Fixed Dividend Rate (as defined herein) applicable to such Subsequent Fixed Rate Period by $25.00. The Annual Fixed Dividend Rate for the ensuing Subsequent Fixed Rate Period will be determined by CIBC on the 30th day prior to the first day of such Subsequent Fixed Rate Period and will be equal to the sum of the Government of Canada Yield (as defined herein) on the date on which the Annual Fixed Dividend Rate is determined plus 4.47%. See "Details of the Offering".